Summary
Over the rest of 2021, investors can be optimistic that effective Covid-19 vaccines will be broadly adopted, and the world economy will likely continue to recover. However, recent price dynamics in risky assets, as well as rising bond yields, warrant some caution. We remain “risk-on”, but we also remain on our toes.
Key takeaways
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Update Magazine I/2021 |
1 Update to our 2021 outlook
Ongoing economic healing, but risks remain
The global economy has recovered from the depths of the Covid-19 recession, even as some countries grapple with new infections and lockdowns. Investors may want to seek out new sources of return potential that could benefit from the evolving recovery story – in addition to sectors that prospered through the crisis in 2020.
Much depends on the successful deployment of effective vaccines and drug therapies. New vaccines have been proven effective, even though new variants of the SARS-CoV-2 virus constitute a challenge to our health and the economic outlook. We will be watching key macroeconomic data points for signs of economic momentum. We expect wide differences in how regions perform – not least because of different virus dynamics.
While an economic recovery remains our base-case scenario, as well as the consensus view, the range of possible outcomes of this growth trajectory is still quite wide (see Chart A/).
A/ A GRADUAL ECONOMIC HEALING
World GDP estimates (quarterly since 2019, indexed to 100)
Source: Allianz Global Investors, OECD. Data as at December 2020.
2 Investment themes to watch for the remainder of 2021
The reflation trade continues in times of ongoing financial repression – for now
Major central banks – notably the Federal Reserve and the European Central Bank – have reiterated their determination to provide ongoing monetary stimulus, in order not to jeopardise the current economic recovery. Nominal central bank rates will remain – most likely – at current levels. In other words, ZIRP (zero interest rate policy) and NIRP (negative interest rate policy) will continue. We should also expect Western central banks not to alter their bond purchase programmes in the foreseeable future. Likewise, governments will continue to support the economic recovery with fiscal stimulus measures. Admittedly, the size of the fiscal packages in 2021 will, most likely, be smaller than in 2020. But notably, the USD 1.9 trillion fiscal stimulus (approximately 9% of US GDP) recently proposed by President Joe Biden could put the US on the fast track to closing its output gap within the next one or two years. This would clearly cause upside risks to inflation – which will likely exceed the Fed’s 2% target in the course of this year anyway, simply because of a base effect related to the energy price recovery. Let’s recall that in April 2020 the WTI (West Texas Intermediate) oil price hit an all-time intra-day low of USD 40 per barrel – an astonishingly low level – while it is currently trading at around USD 60. With nominal rates most likely unchanged, and inflation expected to be on the rise, we think real rates will fall from today’s levels.
B/ GLOBAL EQUITY MARKET VALUATION
Source: AllianzGI, Refinitiv, Data as at 2/2021
What does it mean for investors?
- We are still keeping a slightly “risk-on” stance at this juncture – despite the strong rise in the prices of risky assets since 23 March of last year. This means we have a bias to take long positions in equities and, within fixed income, to take long positions in spread product (such as investment-grade corporate bonds and high-yield debt). We also expect industrial commodity prices to rise further from here.
- Within equities, we continue to broaden out our exposure, both geographically and in terms of investment style. We deem non-US equities to be moderately priced, based on our preferred valuation metric (CAPE, or cyclically adjusted price earnings ratio). As such, we think that non-US equities have a good chance to perform well this year, after having been relative performance laggards in 2020. While we still like technology stocks because of their structural growth potential – our research shows that sectors that were spearheading the technological revolution in the past tended to outperform over several decades – we think value stocks could unleash their value going forward. Depressed valuations and a cyclical recovery are the two arguments in favour of value stocks. (see Chart B/).
- Within fixed income, we expect the yield curve, notably in the US, to steepen further – meaning that the difference in yields between longer-dated bonds and shorter-dated bonds will likely widen. A steeper yield curve usually comes with easy monetary policy and an economic recovery.
- Investors may want to consider inflation-linked bonds – including Treasury inflation-protected securities in the US, and gilts in the UK. These should directly benefit from rising inflation expectations, since they are designed to help protect investors from inflation.
- In line with the comments above, there are also further upside risks to bond yields, and downside risks to bond prices. Given the interconnectedness of financial markets and the global nature of the recovery, we expect bond yields to edge up in all major sovereign bond markets.
- We are also sticking to our bias to shorten the US dollar as a safe-haven currency.
- Gold could keep benefitting from easy monetary policy. There is a close historical connection between high gold prices and environments of low and falling real yields, because people often buy gold when they think other “safe” assets don't offer a better opportunity.
Be aware of the risks to the economy and markets
Admittedly, our risk-on stance is a slightly “nervous” one, as we are fully aware of the three main risks around our benign base case scenario for both the economy and the markets.
The main reasons why the economic growth path may turn out to be flatter than so far anticipated are delays in the roll-out of the vaccines; a refusal by more than roughly 40% of the population to accept the shot in the arm; a faster spreading of the virus (notably of the new variants); and/or an insufficient effectiveness of the vaccines to protect against the new variants. If economic data start to deteriorate, and growth expectations are revised downwards again, risky assets could suffer.
Even though central banks have reiterated that they are holding their course and not adjusting their ultra-easy monetary policy stance any time soon, markets may test their resolve in the course of this year, as inflation rates trend higher. Also, investors may have second thoughts about the longer-term implications of central banks’ sovereign bond purchases, and the unparalleled increase in narrow and broad money supply, on inflation. Just to highlight two numbers here: in the US, the M1 money aggregate grew at almost 70% year-overyear in December 2020. And our measure of excess liquidity (calculated as the 5-year growth rate of US M2 vs real GDP) ran at almost 50% at the end of last year – similar to the readings we observed in the 1970s.
While equity prices in general can stand higher bond yields, especially if they increase slowly, that might not happen this time around. The equity market since 23 March 2020 has been very much driven by the expectation of low central bank rates for even longer. Hence, a rethinking of assumptions about monetary policy could trigger a devaluation not only of bonds, but also of risky assets and gold.
Valuations of some asset classes have become outright expensive. This is notably true for US equities, sovereign bonds and, to a lesser extent, some spread markets.
Indeed, there are some signs that US equities may have already entered bubble territory, as we observe several features that, historically, have been consistent with a substantial overshooting of prices. First, US equity valuations today based on CAPE are back at levels we last saw in 1997–1998 – ie, just when the US tech bubble took off. This holds true for both the S&P 500 and the Nasdaq. Second, US earnings growth expectations are sky-high at almost 24% per annum for the next five years, based on bottom-up consensus earnings expectations. This even dwarfs the optimism we observed in the year 2000 at the peak of the tech bubble. Third, ultraeasy monetary policy in combination with financial market deregulation (notably during the Trump administration) has contributed to a new peak in corporate leverage ratios. Fourth, we have again observed a boom in newly developed financial instruments. Just think of cryptos (and related financial instruments) and SPACs (special purpose acquisition companies – also called “blank cheque” companies). The latter accounted for around 40% of all US IPOs in 2020. Fifth and finally, there are several warning flags about “overtrading” – including the high and rising turnover of stocks, investors’ bullish positioning, and some very unusual or exponential price moves (including bitcoin).
Still, in relative terms, US equities offer better value than bonds for investors with a long-term investment horizon of a decade or so, as the earnings yield of US stocks (the inverse of the CAPE plus an inflation premium) exceeds bond yields by a wide margin. That’s because sovereign bonds offering negative inflation-adjusted yields are very likely to generate negative inflation-adjusted returns in the coming decade (see Chart C/).
3 Sustainable investing provides the long-term view investors need
Beyond cyclical swings and valuations, there is also a longer-term theme that is going to shape markets in the coming years: sustainable investing. It has become even more relevant during the coronavirus crisis.
The pandemic exposed shared vulnerabilities in the global economy, and the systems on which we all rely. Investors will increasingly need to find ways to be selective among sectors and individual names, rather than rely on broad market performance. Environmental, social and governance (ESG) factors can be a helpful lens for highlighting major global risks, and testing the resilience of businesses and systems.
The Covid-19 pandemic also forced many investors to hit the “reset” button and recalibrate their priorities, with policymakers, regulators and investors examining the social effects of economic activity. A growing number of investors will want to put their capital to work in a sustainable way, and they’ll be looking for creative ideas to help achieve meaningful real-life change on topics such as climate change.
This may happen within the framework of the 17 UN Sustainable Development Goals (SDGs), which call for greater cooperation between countries, organisations, companies and individuals to address vital development issues. A 2017 UN report put the SDG funding gap in developing countries at around USD 2.5 trillion per year, making it critical to find innovative and scalable new investment products for the countries and sectors most deprived of funding. This can take the form of public/private partnerships, with parties with similar goals shouldering different responsibilities. The field of development finance – which uses capital and know-how from public and philanthropic sources to mobilise private investment into sustainable development – can play a crucial role here.
For example, given that massive spending is still needed to return parts of the economy to its prepandemic growth trajectory, some governments see an opportunity to rejuvenate existing infrastructure such as electricity networks. This can be done while building the social, environmental and clean-energy projects that will support the wellbeing and prosperity of future generations.
But sustainable investing is not just about doing good – it also helps investors seek solid performance. Approximately two-thirds of active ESG managers in the eVestment database (which tracks institutional asset managers) have beaten the benchmark index for global equities during the last three years. This includes 2020 – an extremely volatile period for equities.
C/ S&P 500 CAPE VS EXCESS EARNINGS YIELD
Source: Robert J. Shiller
What does it mean for investors?
There are many options for investors who want to put their money to work in a sustainable way – particularly as the world recovers from the Covid-19 pandemic.
Corporate governance will be critical as the private sector navigates a deep recession. Well-run companies with solid governance structures may be in a better position than their competitors.
Institutional investors can turn to the private markets to seek financial alpha, while also meeting societal targets – for example, by investing in urban regeneration, enhanced digital infrastructure, social housing, or improved education and health services.
Consider the area of food security, which has garnered more attention during the pandemic as the food-supply chain was disrupted, and an unexpected number of people needed assistance. Companies are making promising developments in the way food is grown, processed and distributed – and they’re looking for much-needed capital from investors.
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The Global Head of Investments, Deborah Zurkow, talks about how sustainability is revolutionising asset management, engagement with businesses and the required standards.